The Financial Stability Oversight Council, led by U.S. Secretary of the Treasury Steve Mnuchin, needs to conduct a thorough analysis of banks’ and non-banks’ exposures to leveraged lending and to collateralized leveraged loan obligations (CLOs), where the majority of leveraged loans are packaged. The Wall Street Reform and Consumer Protection Act (Dodd-Frank) created FSOC and charged it with the responsibility of comprehensive monitoring of the stability of the United States’ financial system. Despite the explosive growth of leveraged lending and CLO issuance, a lot of complacency about leveraged loans and CLOs is taking over investors. Yet, there is a lot that market participants do not know about banks’ direct exposures to leveraged loans and to non-banks which originate leveraged loans, mostly covenant-lite. Moreover, we are even more in the dark about the CLO exposures of non-banks such as pension funds, insurance companies, private equity firms, hedge funds, and university endowment funds. Earlier this year, the Financial Stability Board called for more transparency from non-banks. FSOC’s Office of Financial Research would be the perfect entity to collect and analyze data from relevant bank and non-bank institutions involved in leveraged lending and CLO transactions, were it not for the fact that this administration has gutted OFR.

Moody's analysts follow the leveraged lending market closely.

Mayra Rodriguez Valladares

In a Moody’s report published yesterday, analysts David Fanger, Ana Arsov, and Laurie Mayers wrote that “Compared with the 2006-08 period, most global investment banks (GIBs) have significantly lower direct leveraged lending exposures through their underwriting pipelines and hold portfolios. As a result, the GIB peer group as a whole is resilient to a hypothetical very severe stress of its leveraged lending exposures, with most banks’ stress losses amounting to less than half of firm-wide pretax earnings in the scenarios we tested.” It is important for market participants to pay close attention to a statement in the report “Banks do not publicly disclose a comprehensive view of leveraged lending exposure, but exposure to leveraged loan underwriting is easiest to identify, and GIBs dominate most league tables for this business.” This level of opacity means, market participants have to do more research and we could use help from FSOC and the OFR.

While banks may be holding a lot less in leveraged loans directly than they did during the last financial crisis, it is important not to become complacent about banks’ interconnectedness to the non-banks which are holding leveraged loans. Moreover, as I wrote in April, about 50% of the buyers of CLOs, which is where most leveraged loans are packaged, are banks. In the U.S., the largest holders of CLOs are Citigroup, JPMorgan, and Wells Fargo, and while their holdings as a percent of all their assets are low, what we do not know are these banks’ exposures to non-banks in the leveraged lending and CLO space. Additionally, both internationally active as well as regional banks lend significant funds to private equity and direct lending firms that originate leveraged loans, but the exact amounts are not publicly available.

In their report, the Moody’s analysts detailed that they evaluated how bank earnings would be impacted if there were stresses in the leveraged lending markets. Their research focused on direct leveraged loan exposure. They found that “stress losses as a proportion of capital markets pretax earnings range much higher, suggesting that some firms’ capital markets businesses may be more heavily reliant on leveraged lending and thus more vulnerable to severe stress in leveraged lending.” North Americans would fare much better. Deutsche Bank and CreditSuisse are the most vulnerable to a downturn in the leveraged lending markets.

Despite warnings by regulators and numerous market participants, CLO issuance continues unabated. In the first quarter of 2019 there have been 87 CLO issuances worth $43.8 billion in comparison to 75 deals worth $43 billion in the first quarter of 2018.

U.S. CLO issuance continues to rise.

LCD News

Despite challenges in the European leveraged loan market, LCD News data shows that 2019 European CLO issuance tops the pace of the post-crisis record, last year. Year-to-date there have been 22 deals worth €9.4B in comparison to 21 deals worth €8.7B in the first quarter of 2018.

European CLO issuance is rising despite challenges in Europe.

LCD News.

Last November, Democratic Presidential Candidate Elizabeth Warren asked that bank regulators and the FSOC look into the risks of banks’ exposures to leveraged lending and requested answers by December 11th. In her letter, she asked Mnuchin “The leveraged lending market involves a number of different types of entities that are subject to oversight from a number of different federal regulators. Congress created FSOC to ensure adequate oversight of such cross-cutting markets. In your capacity as the head of FSOC, what is FSOC doing to monitor the growing leveraged lending market and to coordinate responses across the different agencies with relevant jurisdiction? Is the Office of Financial Research looking into the growing risks in this market?” To my knowledge, no answers to her letter have been given publicly.

Senator Sherrod Brown also urged the same last month. He asked that no later than April 23rd he be provided with the following documentation from FSOC:

Any analyses of the leveraged lending market that the Council and its member agencies have performed in the last two years;

Any other Council documents discussing the risks of leveraged lending and staff recommendations to address those risks;

A list of all Council meetings where leveraged lending was discussed, including the dates of those meetings, attendees, and materials presented;

A list of supervisory or other actions that the Council and its member agencies have taken at regulated institutions in order to address risks in the leveraged lending market, especially with regard to weak underwriting standards; and

A description of how FSOC is monitoring leveraged lending markets and what actions it plans to take to protect the economy from threats in credit and lending markets.

Mnuchin should answer their questions in order to provide transparency about the leveraged lending and CLO markets, preferably way ahead of the next economic downturn.